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The Autumn Budget was widely seen as a show of support for EIS, as the legislation was tweaked to encourage investment into ‘knowledge intensive’ companies. But what does ‘knowledge intensive’ really mean, and will the new rules make much difference to EIS investors and the companies they invest in?
This is a preview of an article written by Oxford Capital for GBI Magazine, a publication aimed at helping financial advisers keep abreast of the tax-efficient and alternative investment markets.
For EIS investment managers, November’s Budget was the most nervously anticipated in years. Earlier in 2017, the government published its Patient Capital Review consultation, which revealed a concern that the Enterprise Investment Scheme was not channelling enough money to the right companies. Rumours were rife about what the Chancellor might do in response. Cut the rate of income tax relief? Increase the required holding period? Ban certain industries from participating?
So what happened?
As it turns out, the rumours of changes were not unfounded, as there have been some tweaks to the EIS rules. Indeed, unusually, the planned EIS changes were mentioned from the despatch box rather than being buried in the small print. But the changes are positive.
Firstly, Philip Hammond said he would, “ensure that EIS is not used as a shelter for low-risk capital preservation schemes”. This has already been followed up with the publication of some HMRC guidance, designed to make sure EIS reliefs are only available when the investor’s capital is genuinely at risk.
This renewed focus on risk-taking is to be welcomed, as is Mr Hammond’s other big announcement regarding knowledge intensive companies. These companies already enjoy an enhanced EIS regime, including a lifetime funding limit of £20m (compared to £12m for other companies). Now, knowledge intensive companies can also raise up to £10m of EIS funding (or a combination of EIS, VCT and other state-supported funding) in a year – a doubling of the previous limit. Furthermore, individuals will be able to invest up to £2m in EIS companies in a given tax year, as long as at least £1m of the total is invested in knowledge intensive companies.
What makes a company ‘knowledge intensive’?
For some clients, the phrase ‘knowledge intensive company’ might intuitively mean university spinouts or engineering and life science businesses. And it is theoretically possible that such companies could meet HMRC’s ‘skilled employees’ condition, which forms part of the assessment of whether a company is knowledge intensive. This requires at least 20% of a company’s employees to hold postgraduate degrees in a subject that is relevant to their job and to be engaged in Research & Development activity. In practice it’s a rarity for companies to meet this strict test. Philip Hare, a tax consultant who specialises in advising companies raising or investing through the government’s venture capital schemes, says he has only ever come across two companies that met the skilled employees condition.
But thankfully companies can still qualify as knowledge intensive by satisfying a much broader ‘innovation’ condition. To meet this test, a company must be developing Intellectual Property which could reasonably be expected to form the backbone of the company’s business ten years from the investment. Scientific companies will often meet this condition, but so will companies that can show they are developing ideas or products that can be protected through trademarks, patents or other forms of IP protection.
Furthermore, software including apps and website code can often be classed as intellectual property. This means innovative companies from a huge range of different industries could potentially be counted as ‘knowledge intensive’, because their businesses hinge on exploiting the IP that resides within their websites or apps.
To qualify as knowledge intensive, companies must also have spent a certain proportion of their operating costs on Research & Development or innovation. Relevant expenditure should have been at least 10% of total operating costs in each of the three years prior to the EIS investment, or at least 15% in one of the three years. The detailed rules here are fiddly, but the upshot is simple. Companies can devote the vast majority of their operating costs to other activities and still meet the conditions for qualifying as knowledge intensive.
This is an important point for clients to understand. It means that investing in knowledge intensive companies does not need to equate to participating in a funding round that will be entirely consumed by R&D expenditure. Investing in knowledge intensive companies could mean supporting commercially-focused businesses that will be using the funds raised to finance recruitment, sales and marketing, and other activities that could help grow the business and ultimately generate value for the investor.
What difference will the rule changes make to companies?
The government clearly recognises that innovative businesses are important to the UK economy. Increasing the amounts that knowledge intensive companies can raise each year sends a positive signal.
However, there may not be vast numbers of companies positioned to benefit from the increased limits straight away. Few, if any, EIS investment managers have deep enough pockets to commit £10m to any single company in a given year. Through the Oxford Capital Growth EIS, our diversified EIS portfolio service, we will typically invest between £1m and £2m in an investment round, or sometimes less if it’s the first time we have invested in the business.
That said, it is possible that the rule changes could open the door to greater cooperation and co-investment between tax-efficient investment providers. Currently, we more commonly co-invest with venture capital funds that are not tax-efficient, in part so that we can be involved with bigger fundraising rounds without running into the £5m EIS funding limit. The new £10m limit could theoretically make it easier for us to invest in a company alongside one or more other EIS providers.
But co-investments would need to be carefully managed. If a company in our portfolio performs well and consistently hits its targets, we might expect to invest in it not just once but several times over a period of a few years. If each follow-on investment involves a syndicate of EIS managers, there could be a risk of reaching the £20m lifetime funding cap, preventing us from investing as much as we would have liked. Of course, that £20m cap is tied to the EU’s rules on State Aid, so it’s conceivable that it could eventually change, post-Brexit.
Time will tell…
In summary, after a few months of listening to the rumour mill, Oxford Capital and many other EIS providers were delighted by what we heard in the Budget. Not only does the government continue to support the scheme, but it is actively looking for ways of improving it. Time will tell how much practical difference the doubling of the funding limit for knowledge intensive companies will make for investors and businesses. But in the meantime, there is no doubt that it is a welcome and symbolic step.
This article was first published in the February edition of GBI Magazine.